Question

Financial institutions constantly try to manage risk for different reasons.

• Discuss the objectives of risk management practices for a financial institution.
• Identify some objectives that are pre-loss and other objectives that are post-loss.
• Include some examples and supporting arguments in your discussion.

Answer 1

Risk management enables management to deal with risks by reducing their likelihood or downside impact.It aims to protect the value already created by the organization, but also its future opportunities.

Financial institutions constantly try to manage risk for different reasons due to different type and extent of risks.A successful business needs a comprehensive,well thought out business plan.There are various different types of risks namely Financial risk, Liquidity Risk, Credit Risk, Market Risk, Operational Risk, Strategic Risk etc.

Some of the objectives of risk management practices for a Financial Institution are:

1. Develop a common understanding of risk across multiple functions and business units so as to manage risk cost effectively.

2. Achieve a better understanding of risk for competitive advantage.

3. Build safeguards against earnings related surprises.

4. Build and improve capabilities to respond effectively to low probability, critical, catastrophic risks.

5. Achieve cost savings through better management of internal resources.

6. Allocate capital more efficiently.

Pre-Loss Objectives are:-

1. Manage losses in most profitable way

2. Lessen Anxiety

3. Meeting external and impose constraints.

4. Regular check on the internal threats like internal IT failure etc.

5. Due Diligence

Post -Loss Objectives are:-

1. Recovering the losses and turning them into profits

2. Making the best out of worst situation

3. Analyzing the weakness and threats

4. Amending the policies to favorable terms

5. Effective Strategic Risk Management Policies.

Some Examples of Risk Management can be:

1. Banks suffer loss when they issue loans to consumers who are unable to pay back the loans.When this happens the credit risk management team would have created certain risk management strategies before providing the loans- the bad debt expense account is an example of risk management strategy.

2. Banks need to be more cautious of credit, operational and market risks. Tools like Value at Risk, Monte Carlo simulations, Cash Flow at Risk and others should be applied to test the level of risk and subsequent actions to help contain the risk.

3. Common risk-avoidance activities are underwriting standards, hedges or asset-liability matches, diversification, reinsurance or syndication, and due diligence investigation.

4. Thieves may deploy malware in attempt to takeover customer accounts, breach third party payment processors, and exploit securities and market trading services; hacktivists may use denial of service attacks, publish private information, and deface websites; and cyber terrorists may deploy malware to attack a country by bringing down critical infrastructure including its financial system. Recently, denial of service attacks resulting from international events caused some major financial institutions to address the issue independently. This type of event is not only a nuisance, but can potentially disrupt business and negatively impact reputation. While many larger institutions spend in the hundreds of millions of dollars on data security, there is often a need for additional funds in order to bolster and continue security measures.

5. Online banking now is a competitive necessity, but providing these services presents abundant security challenges, especially via often less secure mobile devices. Failure to provide adequate security can have dire consequences for a financial institution. Not only can a breach be costly, it can result in significant penalties for non-compliance with data security and privacy regulations and most importantly cause significant damage to its reputation. Risk managers therefore need to maintain a comprehensive understanding of the threats along with their institutions exposures and vulnerabilities.